Mortgage escrow analysis demystified

Just found out what my mortgage payment is going to be for the next year, and the escrow amount jumped a bit more than I had expected. So, being the accounting buff that I am, I decided to try and figure out the formula the mortgage company is using to determine the monthly escrow amount. In the past, this has always seemed like some kind of arcane art shrouded in mystery. I would get my escrow analysis statement in the mail, give it a blank stare or two, note whether I was getting a refund check, write down the new mortgage payment, and move on. Well, it turns out that it’s actually pretty simple:

  1. Take the total of last year’s disbursements and divide by 12, to get the base monthly escrow amount.
  2. Multiply by two to get the minimum escrow balance required (two months worth).
  3. Starting with the escrow balance on the anniversary date, figure out the projected escrow balance for each of the next 12 months. To figure the balance for a given month, take the balance for the previous month, add the base monthly amount (from step 1) and then subtract any disbursements that were made in the same month last year.
  4. Find the month where the projected escrow balance is the lowest. If that number is less than the minimum balance from step 2, subtract the two to get the shortage. Most mortgage companies will let you either pay this amount as a lump sum, or spread it out over the next 12 months. In the latter case, divide the shortage by 12 and add the result to the base escrow amount (step 1), to get the final escrow amount.

I broke out my favorite spreadsheet and crunched the numbers for my own mortgage, and came up with exactly the same numbers as the mortgage company. So at least I know they’re not cheating me. From analyzing this method, it seems that it is definitely in one’s advantage to have most of the disbursements happen towards the end of the “mortgage year”. If the payments are skewed towards the beginning of the period, you end up with a higher payment (to satisfy the minimum balance requirement) and a larger balance at the end. If you end up with an overage (projected low balance greater than minimum required balance), the mortgage company is required to refund this to you, but you’re still giving them an interest-free loan (at least in most states).

Then, there’s the question of whether to pay the escrow shortage as a lump sum, or spread it out over 12 months. The answer is pretty simple: crunch the numbers both ways, figure out which method would result in the lowest average monthly escrow account balance, and go with that. In my case, paying the shortage over 12 months was the clear winner.

The nice thing about the escrow analysis process is that it’s very predictable, everything’s based on the disbursements made in the previous year (there’s no hand-waving or estimating of future bills going on). In my case, as soon as I get my July property tax bill, I can figure out next year’s mortgage payment. I’d just as soon not have an escrow account at all (I’m perfectly capable of earmarking the money myself and earning interest on it to boot), but at least I understand the process now.

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